My most recent books are the Leader's Guide to Radical Management (2010), The Leader's Guide to Storytelling (2nd ed, 2011) and The Secret Language of Leadership (2007). I consult with organizations around the world on leadership, innovation, management and business narrative. At the World Bank, I held many management positions, including director of knowledge management (1996-2000). I am currently a director of the Scrum Alliance, an Amazon Affiliate and a fellow of the Lean Software Society. You can follow me on Twitter at @stevedenning. My website is at www.stevedenning.com.

The same thing happens in economics. Take a recent study that set out to shed light on the role of Chinese businesses vis-à-vis American consumers. Galina Hale and Bart Hobijn, two economists from the Federal Reserve Bank of San Francisco, did a study showing that only 2.7% of U.S. consumer purchases have the “Made in China” label. Moreover, only 1.2% actually reflects the cost of the imported goods. Thus, on average, of every dollar spent on an item labeled “Made in China,” 55 cents go for services produced in the United States. So the study trumpets the finding that China has only a tiny sliver of the U.S. economy.

So no problem, right?

Well, not exactly. The tiny sliver happens to be the sliver that matters. What economists miss is what is happening behind the numbers of dollars in the real economy of people.

How whole industries disappear

Take the story of Dell Computer [DELL] and its Taiwanese electronics manufacturer. The story is told in the brilliant bookby Clayton Christensen, Jerome Grossman and Jason Hwang, The Innovator’s Prescription:

ASUSTeK started out making the simple circuit boards within a Dell computer. Then ASUSTeK came to Dell with an interesting value proposition: “We’ve been doing a good job making these little boards. Why don’t you let us make the motherboard for you? Circuit manufacturing isn’t your core competence anyway and we could do it for 20% less.”

Dell accepted the proposal because from a perspective of making money, it made sense: Dell’s revenues were unaffected and its profits improved significantly. On successive occasions, ASUSTeK came back and took over the motherboard, the assembly of the computer, the management of the supply chain and the design of the computer. In each case Dell accepted the proposal because from a perspective of making money, it made sense: Dell’s revenues were unaffected and its profits improved significantly. However, the next time ASUSTeK came back, it wasn’t to talk to Dell. It was to talk to Best Buy and other retailers to tell them that they could offer them their own brand or any brand PC for 20% lower cost. As The Innovator’s Prescription concludes:

Bingo. One company gone, another has taken its place. There’s no stupidity in the story. The managers in both companies did exactly what business school professors and the best management consultants would tell them to do—improve profitability by focus on on those activities that are profitable and by getting out of activities that are less profitable.

Amazon couldn’t make a Kindle here if it wanted to

Decades of outsourcing manufacturing have left U.S. industry without the means to invent the next generation of high-tech products that are key to rebuilding its economy, as noted by Gary Pisano and Willy Shih in a classic article, “Restoring American Competitiveness” (Harvard Business Review, July-August 2009)

The U.S. has lost or is on the verge of losing its ability to develop and manufacture a slew of high-tech products. Amazon’s Kindle 2 couldn’t be made in the U.S., even if Amazon wanted to:

The flex circuit connectors are made in China because the US supplier base migrated to Asia.

The electrophoretic display is made in Taiwan because the expertise developed from producting flat-panel LCDs migrated to Asia with semiconductor manufacturing.

The highly polished injection-molded case is made in China because the U.S. supplier base eroded as the manufacture of toys, consumer electronics and computers migrated to China.

The wireless card is made in South Korea because that country became a center for making mobile phone components and handsets.

The controller board is made in China because U.S. companies long ago transferred manufacture of printed circuit boards to Asia.

The Lithium polymer battery is made in China because battery development and manufacturing migrated to China along with the development and manufacture of consumer electronics and notebook computers.

An exception is Apple [AAPL], which “has been able to preserve a first-rate design capability in the States so far by remaining deeply involved in the selection of components, in industrial design, in software development, and in the articulation of the concept of its products and how they address users’ needs.”

A chain reaction of decline

Pisano and Shih continue:

“So the decline of manufacturing in a region sets off a chain reaction. Once manufacturing is outsourced, process-engineering expertise can’t be maintained, since it depends on daily interactions with manufacturing. Without process-engineering capabilities, companies find it increasingly difficult to conduct advanced research on next-generation process technologies. Without the ability to develop such new processes, they find they can no longer develop new products. In the long term, then, an economy that lacks an infrastructure for advanced process engineering and manufacturing will lose its ability to innovate.”

The lithium battery for GM’s [GM] Chevy Volt is being manufactured in South Korea. Making it in the U.S. wasn’t feasible: rechargeable battery manufacturing left the US long ago.

Some efforts are being made to resurrect rechargeable battery manufacture in the U.S., such as the GE-backed [GE] A123Systems, but it’s difficult to go it alone when much of the expertise is now in Asia.

In the same way that cost accounting and short-term corporate profits don’t reflect the true health of corporations, the economists’ reckoning of the impact of outsourcing production overseas misses the point. Americans are left with shipping the goods, selling the goods, marketing the goods. But the country is no longer to compete in the key task of actually making the goods.

Pisano and Shih have a frighteningly long list of industries of industries that are “already lost” to the USA:

What’s to be done?

With such a complex societal problem, it’s hard not to start from Albert Einstein’s insight: “The significant problems that we have cannot be solved at the same level of thinking with which we created them.” Many actors will have to play a role.

Company leaders: Business leaders need to recommit themselves to continuous innovation and the values and practices that are necessary to accomplish that. i.e radical management. As Pisano and Shih write: “Whether you’re the US firm IBM [IBM] with a major research laboratory in Switzerland or the Swiss company Novartis [NYSE:NVS] operating in the biotech commons in the Boston area, sacrificing such a commons for short-term cost benefits is a risky proposition.”

Investors: Investors need to realize that the companies of the future are those that practice continuous innovation as Apple [AAPL], Amazon [AMZN] and Salesforce [CRM], as compared to companies practicing traditional management, such Wal-Mart [WMT], Cisco [CSCO] OR GE [GE]. Investors need to realize that short-term financial gains are ephemeral: the companies that will generate real value are those that do what is necessary to continuously innovate.

Government: Government has a role to play in protecting and promoting fields of expertise or what Pisano and Shih call “the industrial commons”. Thus: “Government-sponsored endeavors that have made a huge difference in the past three decades include DARPA’s VLSI chip development program and Strategic Computing Initiative; the DOD’s and NASA’s support of supercomputers and of NSFNET (an important contributor to the Internet); and the DOD’s support of the Global Positioning System, to mention a handful.”

Politicians: At a time of poisonously divisive political debate, in which candidates recite anti-government mantras and call for “getting government out of the way of the private sector”, it is time for serious politicians to step up and examine which parts of the private sector are fostering, and which parts are destroying, the economy of the country. They must stop embodying e.e. cummings definition of a politician as “an ass upon which everyone has sat except a man.”

Economists: Economists need to realize that merely adding up the numbers is not enough. They have to look at the meaning behind the numbers. When they trumpet their finding that “Chinese goods are only 1% of the U.S. economy”, it’s akin to saying “we kept the house but gave away the keys.”

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Have you sent this article to the Fed or other economists, CEOs, CFOs, politicians, professors, or other persons who could influence this process? I think it would be a good idea, and I’d be willing to do so. Who do you think would be the most appropriate recipients?

I haven’t sent the article individually to any of the people you mention. I have been rather busy responding the huge number of comments that it has received.

As the article has already received more than 200,000 pageviews and continues to get a lot of traffic each day, I imagine that some economists at the Fed, CEOs, CFOs, politicians or professors have read ir or heard of it. Some influential people have been very helpful in flagging it on Twitter and elsewhere.

So hopefully the word is spreading that this is an important set of issues that urgently needs attention. If you can help in spreading the word further, I would be most grateful.

Let’s all agree that Apple is a software company. Yeah, things like the retina display are nice, but software features like multi-touch are much more important. The hardware is incidental at best, and where that hardware is produced is entirely unimportant. The only reason they have their own hardware is to ensure that their software runs without a glitch. (let’s ignore the death grip antenna issue for the moment). As a result, their gear is less buggy, more stable, better integrated, and easier to use than other hardware-independent platforms like Android and Windows. But it’s not because Apple has an expertise in hardware. They just want the hardware platform stable…the exact platform is, again, incidental. iMac’s are cute, but it’s the MacOS that matters. Can the Chinese copy this hardware and make it better? Yes, but the barrier to entry isn’t the iPod per se…it’s iTunes. In fact, iTunes is driving every other aspect of Apple’s business. Take that away, and Apple becomes much less formidable. Dell, their Chinese manufacturers, and others don’t have the “golden app” that sets them apart, which puts them into the ‘race to the bottom’ bunch. Will this eventually turn around if someone comes up with some gee-whiz battery technology? Doubtful. Again, the software is really what matters.

Thanks for your comment. I agree that Apple’s success is built on software in general and iTunes in particular. Take iTunes away and Apple is a completely different animal.

Yet Apple has always been based on the tight integration of software and hardware. Between 1985 and 2005, most of the world said that Apple had made a colossally stupid mistake by coupling software and hardware together, whereas Bill Gates at Microsoft was a genius by decoupling them.

One could interpret Google’s purchase of Motorola’s phone business as a recognition that it wasn’t a mistake after all, but rather a prescient view of the future, i.e. that trying to do software without control of the underlying hardware is getting to be more and more difficult.

History indicates that it’s risky to conclude either that it’s only software that matters or that only Apple knows how to do the software. Outsourcing creates huge learning opportunities for potential competitors. Overlooking that risk has doomed many U.S. firms.

Thanks for the clarity of your article, it provided some excellent food for thought. I appreciate that enough that I will sign up for a Forbes subscription again (it’s been a while).

The comments here indicate that there is much envy of Apple’s success. Apple’s success didn’t come from being focused on software or hardware per se.

Their success came from being fanatically focused on the user experience, and they have always been prepared to spend years on that before releasing each new product.

When headlinestoo suggests that “The iPhone was a rip off of the LG Prada, shown a full year before at CeBIT Germany,” he or she overlooks that the iPhone had been worked on internally for at least five years before it was first shown to the public. When Samsung is now trying to defend their iPhone-look-alikes in European courts, they have not brought up the LG Prada as prior art…

Oh, and it’s Foxconn (Taiwan) and Flextronics Singapore)… Let’s hope that this name confusion can be laid to rest now…. Both of these companies are extremely competent at manufacturing exactly what you order, in high volume, and they’ve been doing it for decades.

That is both admirable and valuable, but it is not the same thing as coming up with revolutionary new products.

China is seeing massive inflation, and even as they want to control it, they can’t. At the same time, we are heading for strong deflationary pressures here, and some experts are expecting (no pun intended) the landed cost for Chinese-manufactured goods to intersect with the cost of U.S.-made goods in just three years.

My greatest worry is that smart U.S. students will have to go overseas to get a good advanced education, and they may decide to wait things out there while the tea party is busy drowning education and not-yet-profitable core research in the bathtub.

The greek-columned marble-bodied edifices to education? Sell’em off! Perhaps the Chinese could be persuaded that these would make a GREAT investment in a piece of, um, Americana…

In the meantime, some of us will be busy developing a completely new generation of online training for all levels of education, without “page turners” (flipping book pages on the screen), but with use of teaching and learning methods that were found to be effective repeatedly over 4,000 years, before being abandoned again and again in a quest for more complexity and associated professorial pride.

Effective education is my passion, and I am having a great time making things happen in this field.

[Especially since my reliance on primarily one of the two religions mentioned in the comments above allows me to do my work with minimal distraction and interference from poor user interface design or evil gremlins from Eastern Europe, Russia or elsewhere. In fact, for me personally, this choice of "religion" has resulted in a doubling of my productivity, everything else being equal.]

B.J. Ahlen (co-founder of 2 public companies, but not retired yet by a long shot) Santa Monica, Calif.

johnfein, maybe I misunderstood your comment, but it seems you’re stuck in the mindset of corporate america that cause this mess – you equate companies with the economy with society. It’s not the US tech companies you should worry about, it’s the US.

For 20 years I have been saying if a country does not make stuff it cannot remain a significant presence in the world. This article does a great job of articulating the importance of making stuff. Our businesses must stop the primary focus of quarterly profits and take a longer term view or they wont exist in the long term.